The Dangers of Covenant Judgments: Insurers Must Typically Show Fraud or Collusion to Reverse a Determination of Reasonableness

From the Desk of Kyle Riley:

In Washington, an insured and a claimant can settle claims by agreeing to a covenant judgment without the approval of the insurer in exchange for a release from liability and assignment of potential bad faith claims. If the settlement is found to be reasonable, it will set the per se damages for a potential bad faith claim and will also set damages for covered claims. One of the ways for an insurance carrier to contest the reasonableness is by showing fraud or collusion. However, demonstrating that is becoming more and more difficult. 

Claims Pointer:

The Washington Supreme Court reversed the Court of Appeals and held that the trial court did not abuse its discretion in finding the covenant judgment of $1.7 million reasonable. The Court found that the trial court properly evaluated the Chaussee factors, its reasonableness determination was supported by substantial evidence, and the insurer could not prove fraud or collusion. In particular, the court was less likely to find fraud or collusion in the event that there were genuine efforts to resolve the case before the covenant judgment was agreed upon.

Wood v. Milionis Constr., Inc., 198 Wn2d 105 (2021).

Facts:

The underlying facts of this case involved a $1.3 million contract for the construction of plaintiff’s home for which Milionis Construction Inc. (MCI) was the general contractor. Issues arose when construction was halted due to faulty workmanship, leaving the home substantially incomplete and defective. Plaintiffs sued on various grounds including breach of contract, unjust enrichment, promissory estoppel, negligence, and violations of the Consumer Protection Act. The general liability insurer retained an attorney to represent MCI who also retained personal counsel. Experts were hired to evaluate the defects and costs to complete the home. Each calculation varied significantly, ranging from $2.7 million from plaintiff’s expert and $570,000 to $1.2 million from defense experts. The parties then participated in three mediations over the course of two years. Prior to the third mediation, the parties tentatively agreed to settle the case for $399,514.58, but it was contingent on the insurance company agreeing to fund the settlement. Defense counsel advised that the settlement proposal was the best outcome that could be expected, but the insurance company declined to fund the settlement.

The insurance carrier then sought to obtain a declaratory judgment to determine the coverage issues between MCI and the carrier. The federal district court denied the motion. A week before scheduled arbitration the parties stipulated to a $1.7 million settlement with a covenant not to execute and an assignment of claims against the insurance carrier. Before the reasonableness hearing, the insurer was allowed to intervene but its request for a continuance and additional discovery was denied. The trial court ultimately found the $1.7 million settlement to be reasonable. The Court of Appeals reversed the trial court’s reasonableness determination.

Law:

A “covenant judgment” is an arrangement in which an insured defendant settles claims without the insurer’s consent in exchange for a release from liability and assignment of potential bad faith claims against the insurer to the plaintiff. Because a covenant judgment presents the potential for fraud or collusion between the settling parties, the settlement is subject to a reasonableness hearing pursuant to RCW 4.22.060(1).

Washington Courts have recognized nine nonexclusive factors to help guide the reasonableness analysis called the Chaussee factors (from Chaussee v. Maryland Casualty Co., 60 Wn. App. 504, 803 P.2d 1339 (1991), which include the releasing party’s damages, the merits of the releasing party’s liability theory and released party’s defense theory, the relative fault and ability to pay, and evidence of bad faith, collusion, or fraud. Once a settlement is found reasonable, the settlement amount becomes the presumptive measure of an insured’s harm caused by an insurer’s tortious bad faith. This shifts the burden of proving fraud or collusion onto the insurer.

Analysis:

The Washington Supreme Court first held that substantial evidence supported the trial court’s determination of reasonableness. The Court then analyzed the relevant Chaussee factors and found that the trial court had appropriately weighed the competing expert testimony on damages. As to bad faith and collusion, the Court did express some concern that defense counsel was cut out of the settlement negotiations but was more upset by the carrier’s refusal to give the requested settlement authority given the damage exposure. In addition, the Court noted that, unlike other cases where fraud or collusion was shown, there was no pending dispositive motion that had any realistic chance of success, and instead the arbitration was looming if the settlement did not occur. Ultimately the Court found that the trial court did not abuse its discretion in finding that there was no collusion and the Court recognized that the parties turned to the covenant judgment as a last resort.

The Big Picture:

This case is a reminder of the dangers of covenant judgments because of the wide discretion and deference a trial court’s determination of reasonableness is given. Typically, fraud or collusion is the best way an insurance carrier can defeat that determination. This case demonstrates that a trial court can be less concerned about fraud or collusion if the covenant judgment is used as a last resort, there were opportunities for the insurance carrier to settle within the defense counsel’s recommendations, and there are no pending dispositive motions that might weaken or dismiss plaintiff’s claims.